Value Investing: An Intutive Approach to Investing

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Saturday, 17 October 2015

We, as investors, have read a lot about the impact of emotions such as greed and fear on our investment returns. However, there are many such emotions, which, though escapes the limelight, but play an equally important role in success or failure of our investment decisions. In fact, I feel that we may be well prepared psychologically to deal with emotions such as greed and fear because they are extensively discussed by many veteran investors and market participants consistently as key emotional aspects that can have large impact on investment decision. Thus, after a lot of practice and paying tuition fees, we do eventually find a reasonably prudent way to deal with these emotions. However, we completely ignore other human emotions such as envy, that subconsciously play a big role in our decision making process, but are less talked about in the context of investing. Here is what Charlie Munger has to say about it.

"I have heard Warren say a half a dozen times, ‘It’s not greed that drives the world, but envy.’ And you go through the psychology survey courses, and you go to the index: envy, jealousy, in a 1,000-page book — it’s blank! There’s some blind spots in academia, but it’s an enormously powerful thing"

So, it seems that the literature, leave alone investing, even psychology literature has underplayed the role of a very powerful emotion called Envy. What I have learnt through my own experiences is that envy manifests itself in various investment situations leading us to make imprudent decisions at times which can result into permanent loss of capital. In this two part article, I am putting up situations where, I have felt, envy dictating the decision making process subconsciously even without me being aware of it. I have also put in some thoughts based on how I try to handle the influence of "envy". Here are the four such situations

You have given a miss to an investment idea after thorough research based on your reservations while your friend has made an investment and it has turned a multibagger for him

Some stocks/sectors grabs fancy of the market continue to run unabated while one's portfolio or stocks remain range bound at most!

You stay in cash- due to over valued market- and market keeps making new highs

You do not subscribe to IPO while others make quick and hefty gains on listing

I will elaborate on first two situations in Part I and the other two in Part II

Situation 1: You have given a miss to an investment idea after thorough research based on your reservations while your friend has made an investment and it has turned a multibagger for him

I am sure many of us would have faced this situation. We study an investment idea from various angles and decide not to invest due to many reasons including mediocre business quality/reservation on management on quality/extremely high valuations. However, promptly after we have given it a pass, the stock starts moving up at breakneck pace continuously. You still hold your forte/rationale and stick with your decision on not to invest. As if "missing the bus" was not enough, one fine day you come to know that, one your friends who was also looking at the company along with you, had invested in it and is already sitting on 2 bagger. This compounds "missing the bus" pain and make you envious of your friend. From here on, envy will take over your psyche and may lead to one of the following thought patterns

My rationale/thesis was not correct and the reservations that I had are "ignorables" thus I have made an mistake of "omission". I must reconsider my investment decision

Though I have missed the bus, it is still not too late. I can still ride the story if the investment thesis plays out over long term.

Even though, valuations have risen significantly, there will be enough growth to justify this valuation hence I can make decent money from hereon as well

Now, each one of this thought patterns, on its own and in conjunction with each other may have merit. However, on the other hand the combination of "deprival super reaction" and "envy" can lay a perfect trap for an investor to suck him into making a mistake of buying an inferior quality business or business run by mediocre management at high valuation. This can be perfect recipe for a disaster! I have fallen into this trap for Sintex and Opto Circuits. Both these investments have cost me money!

So, what I have learnt from it and what should one do in such situations? With my limited experience, what I have learnt is that it is very important to stick to basics like follwing.

Do not try to re-assess your conclusion based on the same data points/information unless you realize you have made gross mistake. Re-assessment based on same data set may lead to "rationalizing" what you want to infer! Wait for more data points or clear management actions contrary to your hypothesis before re-assessing

If you have done a thorough work, have confidence on your work and stick to it. It is not a good idea to use market movements to vindicate the "merits" of your hypothesis. Market movements, in the short run, are seldom good indicators of correct hypothesis! Always remember, Ben Graham's words that you are neither right nor wrong because people/market agrees/disagrees with it but because your reasoning and data is correct or incorrect.

Even if you feel you have made a mistake in investment hypothesis, do not invest if you do not see valuation comfort. Market, from time to time, gives us a chance to make investment on favorable terms to us. Remember, patience is a very profitable virtue!

Last but not the least, accept that in one's investment journey, one is bound to commit both the mistakes of "omission" and "commission". Learn from it and move on!

Situation 2: Some stocks/sectors grabs fancy of the market continue to run unabated while one's portfolio or stocks remain range bound at most!

Again, many of you will be able to relate to this. This, typically, happens in the early stages of bull market when certain sector/sectors lead the charge of the bull market. However, it may also happen in sideways markets, where defensives continue to advance while the other stocks barely move.

For example, mid cap infrastructure stocks like Kalpatru Power, J Kumar Infraporjects, Sadbhav engineering, MBL Infrastructure, ITD Cementation have risen from 50-100% in last one year. When you look at some article like this and see you portfolio returning 10%, one feels one has missed the rally and start looking at the next big thing that will catch the fancy of the market so that next time you do not miss the quick multibaggers that lie ahead of you.

So what triggers this thought process? Here is how philosophy Kant describes envy

"a reluctance to see our own well-being overshadowed by another's because the standard we use to see how well off we are is not the intrinsic worth of our own well-being but how it compares with that of others"

Thus, it is clearly an "envy trap". The only motivation here to look for "next big fancy of the market" is nothing but the pain arising from the fact that some one else has made more money than you. You are judging your well being (10% return) based on the another's well being (top performing stocks) thus ignoring the intrinsic worth of your well being (10% return). In fact, contrary to the pain of losing out one should be elated by one's performance if we use absolute standard of the intrinsic worth of well being

You have out performed the market by a wide margin as bench mark has only returned 4% in last year

If it indeed is a bull market, as many proclaim, you have beaten the odds as value investor. Typically, value investors, are more likely to under perform the benchmarks in bull market and outperform in bear/sideways market

On the side note, although, I strongly feel that it is futile to look for "next big fancy" of market,one may come across many market participants, who firmly believe in this theory of each bull market led by certain "sectors"! Even if this is the case, it is important to keep following in perspective.

None of the investment wizards like Warren Buffet, Phil Fisher, Seth Klarman or Peter Lynch have made tons of money betting on sectors/next bull market leaders. So, even if you miss the "golden opportunity" of identifying the next bull market leader, you still can make lot of money! Hence, there is no point losing sleep over the "next big thing"

Coming to how do I try to handle this "envy trap" of missing out on multibaggers of the market?

Always set the absolute return expectation and compare your performance with respect to that. So, I have set the goal of outperforming the market by 5-7% over long term. As long as I am able to meet this goal, I should be happy with my performance.

Do not compare your portfolio's performance with the top 10/20 performing stock of the year. It only creates agony and pain and leads you to direction where one is more likely to make a mistake.

Always remember, one is not entitled to outperform everybody and anybody in the market. That will never be the case. There will always be people/funds in the market who will outperform you in a year/over a period.

We must keep in mind that the objective of Investment is wealth creation over a period of time and wealth creation is journey and not a race. As long as one reaches his/her destination in stipulated time, it is deemed success.

Saturday, 18 July 2015

Valuepickr has been instrumental in instilling some key learning and investment approaches in my brief investment journey. I am sure, most of you must have heard about the wonderful work that this forum is doing leveraging the power of collaboration and sharing that not only helps in evaluating an investment idea but also provides highly distilled and yet enormously effective investment frameworks (capital allocation/dissecting the business quality/slotting the business in right category/ capturing the intangibles) for all kind of investor weather amateur or accomplished! Like me, thousands of investors, have gained immensely from this forum. Donald, Ayush, Hitesh ..the founding members of this forum have been guiding force for the forum and have been cornerstone of success of this wonderful idea. So, if you have not yet explored it for your benefit, I strongly recommend it to you to do it now, if you are a serious investor who believes in fundamental investing.

This year Valuepickr completed 5 years of its existence. On that occasion, a meet of the selected forum members were organized at Goa. Around 20 members were invited to attend the meet. I was very lucky and previleged to be part of that meet. Each member was asked to make a presentation on

1) Key learnings from his/her investment journey

2) Broad investment approach of each member.

I am sharing both the presentation here with a small pre-amble on each one of them

1)Key learnings: In the presentation I have focused on few patterns that I have come across that has worked for me. These patterns are the starting point and not the end points. When I see these patterns, I get interested into the idea, and explore it further. I also, deep down, know that in the past, these patterns have resulted in multi-fold gains and hence if I am able to get it right, I can generate superior returns on my investment. However, the caveat here is that, these patterns alone are not sufficient. To make an investment decision, in addition to these patterns, the basic sanity check criteria must be met i.e high business quality, strong balance sheet, decent management quality, respectable return ratios and compelling valuations. I have also highlighted few "traps" that one may fall into, if one is not careful enough...

2)Investment Philosophy and approach: The organizers had done an excellent job by preparing a set of questions relating to one's investment approach that provided a framework for making the presentation. The questions were very intelligently designed and were probing enough to force one to sit back and reflect! I am sure each one of the participant would have to really dwell onto his journey to come out with answers to those questions. The whole experience of going through that process of finding the answer to the questions was extremely enriching. To me it was like articulating the "abstract" idea sitting deep down somewhere in my mind. However, it is important to recognize that at the end of the day, it is "my" philosophy and may not be applicable or effective to any one of you! Each one of you will have "your own" investment philosophy that you are comfortable with and that works perfectly fine for you. Precisely, that is where the beauty lies. In this, there is no "right" or "wrong" philosophy only something that works well and something that does not work so well. Also, as the time passes and one goes through various cycles, the investment philosophy evolves...The striking thing to me, during these sessions, was that despite of significant divergence in approach, there were common tenets that bound us together!

Please feel free to share your views and comments. I will be happy to receive them.

Disclaimer: I am not a registered research analyst as prescribed by SEBI guidelines and any discussion about a particular investment idea shall not be construed as investment recommendation. This is simply articulation of my personal views. Readers shall do their own due diligence and/or seek advise from profession investment advisor before making an investment decision.

Even though, many of us assign great importance to what we buy (quality) and when we buy (valuations), I have seen large number of investors erring in making a right decision on "when to sell" due to lack of structured framework for making a sell decision. This shortcoming has deprived number of investors, even many veterans, of serious wealth creation. Even well informed investors who have realized the merit of buying right, have largely ignored the other part of the advise on "sitting tight"! This is my attempt (knowing my limited experience in the market, it is nothing more but an attempt!) to establish some pointers in making right "selling" decision. In my opinion, one should not sell the stock for any other reason than the one of the five reasons articulated below. All other reasons/rationales attributed for making a "sell" decision can be seriously injurious to investor's ability to create serious long term wealth.

Here are the five reasons which can lead to a credible and beneficial "sell decision"

When we realize that we have made a mistake in making a "buy" decision:

This is the first, foremost and undeniable reason for selling a holding! I am sure almost all of us have gone through scenario number of times in over investing life span. In spite of all our caution and conservatism, we will end up committing mistake/s while making a "buy" decision. Sometimes, we misjudge the quality of business, management or both! At other times, we end up paying too much for buying a business compared to business's future earning power and the quality of earnings. And last but not the least, occasionally, in our urge to buy "statically cheap" stocks, we end up in value traps.

I can enumerate number of such mistakes from my side: Hyderabad Industries Limited, GSFC, GRP Ltd and Sintex (almost all these mistakes are well documented on my blog!) each falling into different category of mistakes (believe me, I have covered the whole range!...:-))

In such situations, the most logical and correct thing to do is to "sell" as soon as we realize that we have made the mistake. Even though selling sounds the most logical course of action in such situations, we seldom take the most rational course of action! Most of the times, in spite of knowing "heart in heart" that we have made a mistake, the innate behavioural traits take the control of our decision making process making us vulnerable to

Commitment and consistency bias: we ignore all the evidences that are contrary to our "hypothesis" for making a buy decision and continue to hold onto our mistakes

Loss aversion: We continue to "hope" that prices will recover on good earnings/corporate action at some point and we will be able to exit with reduced/no loss

Clinging onto our "mistakes" cost us dearly either in terms of permanent loss of capital or in terms of the opportunity cost...Thus, the first concrete realization of our mistake is a genuine reason to hit the "sell" button and it has, in the long run, the ability to improve our financial well being to a great extent!

Due to change in any internal or external factor, if the underlying investment thesis no longer holds true in case of business quality, management quality or valuation

As we all know, the only "constant" in business is change! Hence it is important to re-visit the underlying "investment thesis" for each investment and make a periodic assessment on whether in the present context, the investment thesis still holds true. Even though there is a sound argument for not re-evaluating the merits of an investment very frequently and follow the "buy and forget" philosophy. I feel lot of investors suffer because they follow the "buy and forget" approach in literal sense and don't keep track of changing dynamics on periodic basis...a mistake that may cost them a lot of money! Again, I am not suggesting that each and every development of the company/industry shall prompt us to "re-visit" the investment thesis. Instead, a more judicious approach of regular annual review with exception of earlier review in case of any major internal/external development may be adopted.

Let me share a current example:

When I took a position in MPS Ltd with an investment rationale as follows

" MPS Ltd is a well entrenched player in publishing outsourcing industry with strong relationship with marquee list of clients. MPS is one the leaders in this segment. Publishing outsourcing industry is likely to grow at decent rate due to various tailwinds behind it. MPS, which had fell behind in the game, under previous management due to its high cost structure and lack of growth coming through from 2009-2011, seems well on its way to claim its lost glory under new management. New management, which seems competent, focused and shareholder friendly, has proved its mettle in the first phase of "turn around" by completely altering the cost structure and thus improving margins significantly in last 2 years. Thus, realigning of the business model has resulted turned MPS from a mediocre business to a high quality business generating very high return on capital and free cash flows. Management has allocated the capital well by making acquisitions at decent prices while distributing the significant portion of cash to shareholders as dividends.

Looking at management's rigour on margin improvement and indication about possibility of further improvement in margin, there is still some room for margin improvement. After addressing the margin issue, management is likely to focus growth. Considering the competence of the management and its track record, inherent strength of a strong client relationship and tailwinds for the publishing industry, there is high likelihood that management will be able to deliver decent "growth". At current valuations, the market is pricing in minimal growth and no margin expansion. Hence, the odds are in favour of an investor with limited downside and significant upside, if the hypothesis plays out correctly"

Now let's look at today's scenario:

- Margin improvement story has played out and margins have limited room to improve from here on

- Organic growth has been moderate at best though inorganic growth has been decent

- Valuations have caught up and market is also factoring in 15-20% CAGR

Now, I don't have crystal ball. However, what should I do, if MPS management is not able to bring in the top line growth in next couple of years and valuation remains at level they are today? I need to "re-visit" the hypothesis every year and see if the business is living up to the key rationale of my investment hypothesis

Growth kicking in

Management allocating capital rationally

Re-alignment of business model has made MPS a high quality business

Depending upon the assessment, I shall make a decision of either buy/hold/sell

Other such examples where change in investment thesis may lead to "sell" decision:

Adverse change in management quality either in terms of capital allocation or integrity

Unfavourable changes in external environment such as regulations, policy, new technology,substitute product, change in preference of the consumers etc

Here again in addition to the psychological factors of commitment and consistency bias and loss aversion, "slow contrast effect" may also hinder the rational decision making . Slow contrast effect is evident when there is slow but steady change that is visible to investors quarter on quarter and year on year, however goes unnoticed/is ignored as the quantum of change is too small. Ideally, these small changes happening consistently, without any strong reasons attributable to it shall act as an early signal to re-evaluate the investment thesis for any material changes in external/internal environment (For e.g.working capital as % sales increasing slowly but steadily or After years of constant/increasing margins, the margins are consistently shrinking by a small fraction every year) . However, these early signals get ignored due to the "small quantum" of change and is disregarded due to its marginal effect until the resultant cumulative effect is large enough to be visible. And many a times, it is too late, by this time!

If in a portfolio, allocation to a single business remains much above the upper limit of allocation on sustained basis

The third credible reason to make a "sell" decision is for "risk averse" people like me. Here, the driving force for making a sell decision is not linked to merits/de-merits of an investment but is linked to an investor's ability to bear risk in case of extreme adversity. I acknowledge that many of the investors may not agree with this approach of hitting the "Sell" button when the decision making process is not "centred" around the attractiveness of an investment on standalone basis. However, I feel that it may be of great importance to people who run a portfolio with small base and are prone to make errors of judgement. In this context, it shall become a credible reason to sell.

All of us adopt different approaches to capital allocation with the portfolio falling into category of highly diverse with more than 30 stocks to highly concentrated with less than 5 stocks. However, in all these approaches, one aspect that an investor must "calibrate" is the maximum allowable allocation to a single stock. This number may vary from investor to investor from 10% to 40% or even for some investors up to 50%.

Prime objective of setting the maximum allocation to single business in a portfolio is to manage the risk of one or more negative event/s resulting into very large permanent loss of capital. It is a mechanism, to a degree, to comply with an old adage of not putting one's all eggs in one basket. I have come across many long timers in the market who faced extremely severe erosion of their net worth for either not setting the maximum allocation limit right or not being disciplined enough to stick to the limit set in the beginning.

This situation typically arises, when one of the portfolio's sizeable holdings out performs the other holdings by a large margin thus increasing the initial allocation multi fold to exceed the maximum allocation by a wide margin. Take the example of a portfolio of 10 stocks with each starting with 10% allocation with maximum allocation limit of 20%. In 3 years, stock A turns out to be a 5 bagger while the rest of the portfolio giving 66% return. Thus the overall weight of stock A in the portfolio becomes 40%, i.e. double the maximum allocation limit. Even though, many people may advise you against selling one's winners,it may be prudent to be disciplined and sticking to the limits and booking some profit to bring down the allocation to the maximum allowable limit (or very rarely, to re-set the maximum allowable limit, in case if the risk appetite of an investor has changed)

If the Investor comes across a much better investment opportunity that offers significantly higher risk adjusted returns than the existing portfolio holdings:

Let me start with a warning. One should tread this path with extreme caution as an investor is vulnerable to mistakes every time he/she makes a decision to switch. This is especially the case when such decision is made in absence of a mistake or change in investment thesis of existing holding. Hence, if one finds that, every 6 months he/she comes across a much better investment opportunity that will necessitate the churn in the portfolio, more likely than not, he/she is not making the right "buying" and/or capital allocation decision.

Having alluded to this pitfall, there are situations in one's investment journey where one comes across extremely attractive investment opportunity but does not have adequate cash available to capitalize on the opportunity . At this point, selling one of the existing portfolio holdings will make sense as risk adjusted "opportunity cost" of not selling may be very high . However, while making this decision to sell, investors may keep following criteria in the mind

New opportunity shall be significantly superior both in terms of conviction level, business quality and valuation to the least attractive holding in the portfolio. One should pass away any such opportunity, if the new opportunity is likely to be only "marginally" better than an existing one in any of these aspects, simply because of the re-investment risk involved in the process is too high.

Investor shall have a structured framework to arrive at relative merits/attractiveness of each holding in its portfolio (one such excellent discussion is on valuepickr) and then sell the "least attractive" holdings

Again, I would want to re-iterate that, if one is required to sell one of its holdings for this reason too often, he/she should seriously re-look at the frame work and rigour that he/she is adopting for making a "buy" decision.

The markets pendulum swings to undue exuberance resulting into market valuations (measured through benchmarks) that are more than 2 standard deviations away from the average historical benchmark valuations

This again is an area where the decision to "sell" is driven by the risk aversion and not through business fundamentals. Hence the central driving force behind "selling" at this time of heightened optimism is two fold

Converting the paper profit (which may evaporate in a jiffy!) into hard cash thus protecting the "net worth" from severe erosion, in case of impending severe crash

More importantly, creating a war chest in terms of cash to take advantage of exceptionally attractive opportunity that may arise after the impending crash

(yes! the underlying assumption is that market will eventually crash..an unwritten rule of the market). As Mr.Buffet puts it "Cash in time of crisis combined with courage is priceless"

Here again what percentage of portfolio shall be monetized is a question that isa function of individual capital allocation approach. However, investor will be well served, if they adopt a structured approach as mentioned above of rating one's portfolio holdings from most attractive to least attractive based on the framework of business quality, conviction level and valuation. Based on the attractiveness of each portfolio holdings, investor may sell the least attractive holdings to generate cash level that he/she is comfortable with.

Even though, this sounds simple while writing, it takes exceptional courage to take the money off table while the money is literally multiplying and everybody shouting from the roof top that "best is yet to come" and "this time it is different!" Even more painful is to watch other investors make money on the same holdings you have sold for a while (This is bound to happen as the market, like a true maniac, moves to extreme and hence may even move higher from already unsustainable elevated levels )! One has to overcome extremely powerful interplay of psychological forces namely greed, envy and scarcity to make these "sell" decisions! Nevertheless, one who displays strong resolve and discipline in this situation is bound to be rewarded with a bountiful in the long term!

It goes without saying that, this ground rules are based on my limited understanding of how things may work in market and by no means conclusive. At the same time, I also feel that the above five category of reasons cover a broad expanse of credible reason to make "sell" decision. Conversely, any reason not falling under any of these five categories leading to "sell" decision shall be looked with deep suspicion!

Disclaimer: Nothing in this article shall constitute an advise to either buy or sell to any individuals. I am not a research analyst and the views here shall not be construed as an advise coming from a research analyst. The views expressed on this blog are only for engaging in discussions with like minded people on various investment related subjects. Individuals shall consult their financial advisor for making any investment decision.

Thursday, 6 November 2014

"To be or not to be"... are the opening words of the world famous Shakespearean play Hamlet in the context of quandary that Prince Hamlet faces with respect to weather to live a miserable life or to end the life and embrace the unknown after death.The dilemma that an investor faces is no less perplexing and multi-dimensional than the words of prince Hamlet. I am reasonably convinced that making a correct decision to Sell is as important as making the decision to Buy for generating above average returns over a long period of time. There is ample material and thorough discussions around how to make a prudent buying decision, however, I have yet to come across a well developed and comprehensive framework on "how to sell".

In absence of any structured framework and principles/ground rules, the decision to sell is many a times arbitrary even for seasoned investors. However such arbitrariness is counter-productive to the very objective of generating above average returns for investors. I have formed some ground rules while making a decision to sell which I refer to while making the decision to sell. Obviously, I am just a beginner in this long journey of investing world and as one progresses through this journey, these rules are likely to evolve/change based on the real-world experiences that I will live through in the market. It goes without saying that I will end paying some hefty tuition fees in the process as well! Notwithstanding, stick my neck out and adhere to these rules till proven wrong...

When not to sell:

Before we start discussing when an investor should sell, it is extremely important to understand when NOT to sell. I have in my initial years made a very costly mistake because of not knowing "when not to sell". However the only solace I can have is that I have the esteemed company of some very senior and serious investors in this! I have come across many investors who have spent enough years in the market and still continue to sell for the wrong reasons. Many a times, this "cashing out early" results into a huge opportunity loss for an investor, especially if he/she has bought into a high quality business at right price. So what are some of those reason where investors feel compelled to sell without realizing that they are making mistake? Here they are

Thursday, 17 July 2014

Since my last post in mid march, the market has briskly moved upwards and sentiments have changed dramatically. Many market players and analysts have proclaimed that the "decisive victory" for the BJP led NDA in general elections is going to be the game changer. It is felt that the new government will usher in the "directional" changes for Indian economy leading to structural bull market for many years to come. This "optimism" has clearly reflected in the way market has behaved since May 16. In last 4 months, Indices have increased by 20% and broader market has outperformed indices by significant margins. Personally, I do agree that there are some palpable green shoots on number of front and pro-business and stable government can bring the "growth" back to Indian economy. However,at the same time I also believe that it is still too early to treat the current economy and business environment as "clear sky"!

For a bottom-up value investor, the market gyrations are less relevant though rising market does pose a challenge of "bargains" suddenly disappearing from the horizon! I am sure like me, many of you would have given a pass to some high quality businesses because of the steep valuations or would have stretched "paying up for quality" theory to the extreme for justifying the "buy" decision at high valuations. However, in this market it is increasingly important to focus on "value" and not get carried away by various "rationales" offered by number of market participant for paying up! In this market and with current valuations, it is important to recognize the fact that one may not encounter the opportunities to make 5-10 baggers in 3 years like it used to exist 3-4 years ago in businesses like Mayur/Cera/Atul Auto and many others. The prudent approach should be to invest in companies with strong, scalable and differentiated business models run by efficient and ethical management by paying up "fair value". In numerous companies that I have analysed in the past 3 months, I have identified 4-5 such companies which fits the bill in my opinion. In this post, I am going to talk about Ashiana Housing Limitedwhich belong to real estate sector and in my opinion has sustainable, scalable and differentiated business model. The company is also available at decent valuations, making it all the more interesting.

Ashiana Housing Limited:

I must admit that I too fell prey to stereotyping real estate companies and ignored AHL in spite of AHL popping up in the my stock screener number of times in last 3 years. However, once I completed my analysis recently, I realized how far the realities can be from stereotypes! I have no hesitation in saying that AHL's annual reports are the best amongst the ARs that I have come across so far. They provide clear and accurate picture about the dynamics of the business and substantiates the same through enough information to validate what they tell about business. Management clearly articulates the risk and limitations while defining the way forward with clear road map. Even if you decide not to move ahead with further analysis of the company in this article, my sincere request to you is to read the ARs once to understand, what it takes to provide holistic and accurate perspective to shareholders about the business! Now let's talk about the business.

Saturday, 15 March 2014

Long term and disproportionate wealth creation is a dream chased by many of us. Value investing is not-so-exciting yet perfect to tool to achieve this objective in the long run. As we all know value investing is all about investing in businesses at price substantial discount to its intrinsic value. It's all about buying "$1 worth of business at 50 cents". However, I personally feel that identifying an investment idea based on value investing principles is only half the job. It is a necessary but not a sufficient condition to achieve the long term objective of disproportionate wealth creation. We still have a missing piece in the puzzle..and the missing piece is capital allocation! What I have observed is that many a times we keep generating very good ideas but fail to allocate capital that each idea deserves. We end up over/under allocating capital to some very good and not so good ideas.

In the initial few years of my journey in value investing, I was solely focused on stock-picking and paid very little attention to allocation of the available capital amongst my ideas. Allocation of capital was completely arbitrary. However, as I interacted more with some seasoned investors, I realized how important capital allocation was for disproportionate wealth creation! Even on most of the blogs and forums focusing on value investing, the discussion threads largely revolve around stock ideas and capital allocation is seldom discussed. I still don't know why it is so as most of the senior investors invariably point out the importance of capital allocation in wealth creation. My guess is, because the stock picking exercise is far more stimulating than following a dodged process of capital allocation.

It is very difficult to outline complete capital allocation framework and process in this blog. However, there is an excellent discussion thread on this topic at Valupickr that I would recommend all of you to go through! It's worth your every minute that you spend on it! However, in this post I will try to present distilled ideas from the valuepickr thread and learning from some well known value investors on capital allocation principles with my own "idiosyncrasies" superimposed on them!

Optimal number of stocks in a portfolio: This is one topic on which I have witnessed many discussions which never end conclusively! Proponent of both concentrated portfolios and diversified portfolio pound on the other side with merits of their own philosophy and de-merits of others's philosophy. Here are some key ponderables for an investor

One must achieve a balance between sufficient diversification and dilution in return from potential winners due to diversification. Let me give you an example: Consider two portfolios of same size 40 Lakhs but having different capital allocation.

Now let's assume that in 5 years one of the stocks turns out to be a 10

bagger, 1 stock 5 bagger and both the stocks are common to both the

portfolios and rest of the stocks generate average return of 15%

annually. Following will be the performance of both the portfolio

Port. A: 38 * (1.15^5) + (1*10) + (1*5)= 91 Lakhs= 18% CAGR in 5 yr

Port. B: 32 * (1.15^5) + (*10) + (1*5)= 124 Lakhs= 25.5% CAGR in 5 yr

So the investor who diversifies highly and have substantially lower allocation to its "winners" will generate far lower returns than the

investor who commits substantial capital to its potential winners.

Naturally, the opposite of this scenario is if investor made a mistake and

incurs permanent loss of capital. The returns in a less diversified

portfolio will be lower than a highly diversified portfolio. However, two

things are important to consider in loss of capital scenario

1) As a value investor, one always tries to avoid/minimize permanent

loss of capital. Hence if the due process is adhered to, the probability

of permanent loss of capital shall be less

2) It is important to recognize that investor's limit to downside is

maximum 100%. You can't lose more than 100% of your money in

stock while theoretically there is no limit on upside. What if you stumbled upon a 100 bagger? your upside will be 10,000%

So, how do you strike a balance? How much is good enough to diversify

enough to cover risk while gaining decent "kicker" on returns from your

"winners"?

My personal take is 12-15 stocks provides reasonable diversification while still giving decent upsides from potential 5,10, 50 and 100 baggers! Having 12-15 stocks on portfolio will ensure that each of the ideas get decent allocation and hence a winner can create serious wealth for the investor

Capital allocation based on judicious mix of different investment approaches:

Even within value investing framework, different investors follow different investment approach and yet generate remarkable superior returns compared to benchmarks. Even though each investment approach has its own advantages and limitations, at the heart of each of these approach remains three golden words of investing "margin of safety". Even though such as deep value investing, growth at reasonable price, high quality businesses at fair price, turn around, cyclicals and special situations. My hypothesis based on the understanding that I have gained by analysing the investment return of various successful investors following different investment approaches is as follows:

Investments under each investment approach behave differently under

specific market conditions and is likely to under-perform or outperform the market under given market conditions. Hence, creating a portfolio of stock covering various investment approaches can increase the likelihood of out-performance across varying economic conditions and market cycles.

So stocks in one's portfolio belonging to high quality business bought at fair price (ITC/Colgate/Asian Paints/Pidilite) are well placed to outperform in the declining market because of the high predictability of the business and consistency in performance. At the same time, same set of companies are likely to under perform in rising markets. On the other hand cyclicals are likely to display quite the opposite behaviour i.e. out performing in rising markets while significantly under performing in the declining markets. Similarly, a well understood special situation is likely to provide significant out performance in declining market while may under-perform in raging bull market.

However, this does not mean that one has to consider allocation to all investment approaches all the time. The ideas is to be open and flexible in trying and understanding various approaches instead of sticking to just one particular approach and take advantage when appropriate opportunity arises. Having said this, two important things shall be kept in mind

Even though investment in turn around and cyclicals can yield excellent returns if one has acquired the skill of spotting cycles and sustained recovery in ailing companies, in general, the failure rate is much higher and one is more prone to incur permanent loss of capital if the prediction about length of cycle or end/start of cycle does not work out as assumed

Irrespective of the investment approach used for selecting an investment, the basic tenet of "margin of safety" must be followed.

I will cover some other important points in capital allocation framework in the next part

Capital allocation based on conviction,business quality and valuation.

Cash allocation in the portfolio

Displacing the existing investment with new idea

Rebalancing the portfolio (Sell decisions and entry of new investment ideas)

Monday, 10 February 2014

When I first listened to the famous speech delivered by Steve Jobs at Standford University, my reaction was similar to that of many others. I was moved, motivated and challenged! But as it had happened numerous times in the past, I assumed that the effect of this too would be ephemaral. However, as years passed by, the words spoken by this self made creative genius, lingered onto my psyche much longer than I had anticipated!

"Your work is going to fill a large part of your life, and the only way to be truly satisfied is to do what you believe is great work. And the only way to do great work is to love what you do. If you haven't found it yet, keep looking. Don't settle. As with all matters of the heart, you'll know when you find it. And, like any great relationship, it just gets better and better as the years roll on. So keep looking until you find it. Don't settle.

And

"Your time is limited, so don't waste it living someone else's life. Don't be trapped by dogma — which is living with the results of other people's thinking. Don't let the noise of others' opinions drown out your own inner voice. And most important, have the courage to follow your heart and intuition. They somehow already know what you truly want to become. Everything else is secondary "

Eventually, One more emotion that his speech evoked was that of "determination"! Determination to follow my heart and eventually settle for nothing less than what I like doing for rest of my life with same passion. I kept looking, with the hope that one day I will come across something which will garner my undivided attention. Something that will ignite passion and give satisfaction every time I did work. Then came a moment, when I was introduced to this concept of Value Investing.It was indeed "love at first sight!". Simple, subtle and powerful! But, as in love, the first impression and first reactions can sometimes be treacherous. One has to spend enough time with each other before making a life long commitment! Hence, I started spending more and more time to get better grasp of value investment philosophy. Warren Buffet, Charlie Munger, Phil Fisher, Peter Lynch, Mohnish Pabrai, Howard Marks, Seth Klarman, Prof. Sanjay Bakshi and many other senior value investors became my "virtual" gurus! I was learning vicariously.. following the teachings of my great gurus! With all the theories and concepts in stride, now was the time to test my mettle in the battleground and start investing serious money! It's been 4 years since I started managing my personal and family's capital by applying value investing philosophy. Though 4 years is not a long time in life span of an investor, the results so far has at least given me the confidence to pursue this journey further. It is satisfying to note that in the tumultuous market of last few years, I have been able to compound the capital at more than 40%+. Also for each of the individual years and cumulatively, the fund has outperformed the benchmarks by a wide margin. These four years have also been fabulous in terms of learning new concepts, meeting some well entrenched value investors and paying up "huge tuition fees" for the mistakes I made!

Hence, finally, I felt the time had come to make the commitment! I have decided to devote significant portion of my time to Investing. To begin with, I will largely manage my friends and family's portfolios. The scope may expand eventually, but definitely not for now. I also intend to eventually start an investment advisory firm rooted in value investment philosophy. My motivation to start an investment advisory stems from my strong belief that value investing is an extremely powerful and yet hugely underrated and unknown philosophy for creating disproportionate long term wealth for many ordinary mortals like me! I can add my "bit" of value to the society if I can help some people create wealth from themselves.

I also want to acknowledge that taking this decision was not easy at all! It meant making tough choices. It also meant, changing the status quo. It meant, moving out of the realms of known world to chartering into hitherto unknown territories. Though it was difficult, I had a promise to keep to myself! Once again quoting Steve Jobs showed me the way

"You have to trust in something — your gut, destiny, life, karma, whatever. This approach has never let me down, and it has made all the difference in my life"

One thing that I have realized in last 4 years that I have spent as an active investor: Ability to correctly differentiate between risk and uncertainty can be very rewarding. In the same vein, it is also equally true, that not getting this distinction right can result into substantial permanent loss of capital. I only wish that I have got this distinction right this time.....

Value Investing Readings

About Me

Hi, I am currently working as a consultant in energy sector with focus on sustainable development. Since last 3 years I have been fascinated with the value investing philosophy and trying to put that philosophy into practice for last 2 years.